The false analogy is in equating the mining of gold with the mining of bitcoin. Paul Krugman made the same mistake here: Adam Smith Hates Bitcoin. Here is the offending passage in Buiter's notes:

John Maynard Keynes once described the Gold Standard as a “barbarous relic”. From a social perspective, gold held by central banks as part of their foreign exchange reserves merits the same label, in our view. The same holds for gold held idle in private vaults as a store of value. The cost and waste involved in getting the gold out of the ground only to but it back under ground in secure vaults is considerable. Mining the ore is environmentally damaging, especially if it involves open pit mining. Refining the gold causes further environmental risks. Historically, gold was extracted from its ores by using mercury, a toxic heavy metal, much of which was released into the atmosphere. Today, cyanide is used instead. While cyanide, another toxic substance, is broken down in the environment, cyanide spills (which occur regularly) can wipe out life in the affected bodies of water. Runoff from the mine or tailing piles can occur long after mining has ceased.

Even though, from a social efficiency perspective, the mining of new gold and the costly storage of existing gold for investment purposes are wasteful activities, they may be individually rational. The same applies to Bitcoin. Its mining is socially wasteful and environmentally damaging.

No, no, no and no. This analogy is all wrong.

Let me be clear about this. Bitcoin costs zero to produce. If one had control over the protocol, one could instantly and costlessly create as many bitcoins as one wanted. No environmental waste, no effort needed. The same is not true of gold.

But wait a minute, you might say. Doesn't mining for bitcoins require effort, consume resources, etc.? The answer is, yes, it does. But this fact does not make the analogy correct (though one can certainly understand why the analogy seems to be correct). Let me explain.

The purpose of gold miners is to prospect for gold. The purpose of Bitcoin miners is not to prospect for bitcoins. The purpose of Bitcoin miners is to process payment requests. A bank teller also processes payment requests. To say that miners are mining for bitcoin is like saying that tellers are mining for dollars. Understand? Let me try again.

Gold miners prospect for gold. But they do not necessarily get paid in gold. In fact, if they work for gold companies, they are likely to get paid in dollars. But they could get paid in gold, or anything else, for that matter. How they get paid does not take away their basic function, which is to discover new gold.

Bitcoin miners, like bank tellers, process payments. Miners, like tellers, want to get paid for the service they provide. It really does not matter how they are paid. As it turns out, miners are paid in the form of newly-issued bitcoins (as well as old bitcoins offered as service fees by transactors). But this does not mean that they are "mining for bitcoin" any more than a bank teller is "mining for dollars."

But isn't mining for bitcoin "wasteful?" In a sense, yes, but again, the "waste" here is not the same as the waste associated with commodity money. Again, let me explain.

We live in a "second-best" world, where people lie and cheat. In a first-best world, money would not even be necessary (see my post here: Evil is the Root of All Money). It is unfortunate that we need Bitcoin miners (and tellers) to process payments. But the resources consumed in this process are necessary, given the safeguards that have to enforced to ensure the integrity of the payment system.

The waste associated with mining gold is that in principle, gold money can be replaced by paper money (and please, do not give some weird "out of thin air" argument; see here.) Paper money, like Bitcoin, and unlike gold, is (near) costless to produce.

Note: Of course, the limit on the supply of bitcoin is determined by a community consensus on following the protocol that adopts the 21M limit. Bitcoin advocates argue that this "hardwired" protocol that governs the supply of bitcoin is more reliable and less prone to political manipulation relative to existing central banking systems. This all may be true, but does not take away from my argument above concerning the false analogy between gold and bitcoin.

Tuesday, November 18, 2014

Well, hold on for a moment. Take a look at the following diagram, which tracks the Japanese real GDP per capita since 1995 (normalized to equal 100 in that year). I also decompose the GDP into its expenditure components: private consumption, government consumption, private investment, and government investment (I ignore net exports). The GDP numbers go up to the 3rd quarter, the other series go up to only the 2nd quarter.

In terms of what we should have expected, I think it's fair to say that most economists would have predicted the qualitative nature of the observed dynamic in response to an anticipated tax hike. That is, we'd expect people to substitute economic activity intertemporally--front loading activity ahead of the tax hike, then curtailing it just after. And qualitatively, that's exactly what we see in the graph above. But does the drop off in real per capita GDP really deserve all the attention it's getting? I don't think so. The fact that the economy was a little weaker in the 3rd quarter than expected (the two consecutive quarters of GDP contraction is what justified labeling the event a "recession") is not really something to justify wringing one's hand over. Not yet, at least.

The idea of "supply" and "demand" is rooted in Marshall's scissors (a partial equilibrium concept). The supply and demand framework is an extremely useful and powerful way of organizing our thinking on a great many matters. And it is easy to understand. (I have a pet theory that if you really want to have an idea take hold, you have to be able to represent it in the form of a cross. The Marshallian cross. The Keynesian cross. Maybe even the Christian cross.)

The Marshallian perspective is one in which commodities are traded on impersonal markets--anonymous agents trading corn and human labor alike in sequences of spot trades. Everything that you would ever need to buy or sell is available (absence intervention) at a market-clearing price. The idea that you may want to seek out and form long-lasting relationships with potential trading partners (and that such relationships are difficult to form) plays no role in the exchange process--an abstraction that is evidently useful in some cases, but not in others.

I think what Roger means to say is that (repeat after me) the abstraction of anonymity, when describing the exchange for labor services, is a bad one. And on this, I would wholeheartedly agree (I've discussed some of these issues in an earlier post here).

Once one takes seriously the notion of relationship formation, as is done in the labor market search literature, then the whole concept of "supply and demand" analysis goes out the window. That's because these well-defined supply and demand schedules do not exist in decentralized search environments. Wage rates are determined through bargaining protocols, not S = D. To say, as Roger does, that demand does not always equal supply, presupposes the existence of Marshall's scissors in the first place (or, more generally, of a complete set of Arrow-Debreu markets).

And in any case, how can we know whether labor markets do not "clear?" The existence of unemployment? I don't think so. The neoclassical model is one in which all trade occurs in centralized locations. In the context of the labor market, workers are assumed to know the location of their best job opportunity. In particular, there is no need to search (the defining characteristic of unemployment according to standard labor force surveys). The model is very good at explaining the employment and non-employment decision, or how many hours to work and leisure over a given time frame. The model is not designed to explain search. Hence it is not designed to explain unemployment. (There is even a sense in which the neoclassical model can explain "involuntary" employment and non-employment. What is "involuntary" are the parameters that describe an individuals' skill, aptitude, etc. Given a set of unfortunate attributes, a person may (reluctantly) choose to work or not. Think of the working poor, or those who are compelled to exit the labor market because of an illness.)

Having said this, there is nothing inherent in the neoclassical model which says that labor market outcomes are always ideal. A defining characteristic of Rogers' work has been the existence of multiple equilibria. It is quite possible for competitive labor markets to settle on sub-optimal outcomes where all markets clear. See Roger's paper here, for example.

The notion that supply might not equal demand may not have anything to do with understanding macroeconomic phenomena like unemployment. I think this important to understand because if we phrase things the way Roger does, people accustomed to thinking of the world through the lens of Marshall's scissors are automatically going to look for ways in which the price mechanism fails (sticky wages, for example). And then, once the only plausible inefficiency is so (wrongly) identified, the policy implication follows immediately: the government needs to tax/subsidize/control wage rates. In fact, the correct policy action may take a very different form (e.g., skills retraining programs, transportation subsidies, job finding centers, etc.)

Monday, November 10, 2014

There's been a lot of talk lately about the so-called "Neo-Fisherite" proposition that higher nominal interest rates beget higher inflation rates (and vice-versa for lower nominal interest rates). I thought I'd weigh in here with my own 2 cents worth on the controversy.

Let's start with something that most people find uncontroversial, the Fisher equation:

[FE] R(t) = r(t) + Π (t+1)

where R is the gross nominal interest rate, r is the gross real interest rate, an Π is the expected gross inflation rate (all variables logged).

I like to think of the Fisher equation as a no-abitrage condition, where r represents the real rate of return on (say) a Treasury Inflation Protected Security (TIPS) and (R - Π) represents the expected real rate of return on a nominal Treasury. If the two securities share similar risk and liquidity characteristics, then we'd expected the Fisher equation to hold. If it did not hold, a nimble bond trader would be able to make riskless profits. Nobody believes that such opportunities exist for any measurable length of time.

Let me assume that the real interest rate is fixed (the gist of the argument holds even if we relax this assumption). In this case, the Fisher equation tells us that higher nominal interest rates must be associated with higher inflation expectations (and ultimately, higher inflation, if expectations are rational). But association is not the same thing as causation. And the root of the controversy seems to lie in the causal assumptions embedded in the Neo-Fisherite view.

The conventional (Monetarist) view is that (for a "stable" demand for real money balances), an increase in the money growth rate leads to an increase in inflation expectations, which leads bond holders to demand a higher nominal interest rate as compensation for the inflation tax. The unconventional (Neo-Fisherite) view is that lowering the nominal interest leads to...well, it leads to...a lower inflation rate...because that's what the Fisher equation tells us. Hmm, no kidding?

The lack of a good explanation for the economics underlying the causal link between R and Π is what leads commentators like Nick Rowe to tear at his beard. But the lack of clarity on this dimension by a some writers does not mean that a good explanation cannot be found. And indeed, I think Nick gets it just about right here. The reconciliation I seek is based on what Eric Leeper has labeled a dirty little secret; namely, that "for monetary policy to successfully control inflation, fiscal policy must behave in a particular, circumscribed manner." (Pg. 14. Leeper goes on to note that both Milton Friedman and James Tobin were explicit about this necessity.)

The starting point for answering the question of how a policy affects the economy is to be very clear what one means by policy. Most people do not get this very important point: a policy is not just an action, it is a set of rules. And because monetary and fiscal policy are tied together through a consolidated government budget constraint, a monetary policy is not completely specified without a corresponding (and consistent) fiscal policy.

When Monetarists claim that increasing the rate of money growth leads to inflation, they assert that this will be so regardless of how the fiscal authority behaves. Implicitly, the fiscal authority is assumed to (passively) follow a set of rules: i.e., use the new money to cut taxes (via helicopter drops), finance government spending, or pay interest on money. It really doesn't matter which. (For some push back on this view, see Price Stability: Is a Tough Central Banker Enough? by Lawrence Christiano and Terry Fitzgerald.)

When Neo-Fisherites claim that increasing the nominal interest rate leads to inflation, the fiscal authority is also implicitly assumed to follow a specific set of rules that passively adjust to be consistent with the central bank's policy. At the end of the day, the fiscal authority must increase the rate of growth of its nominal debt (for a strictly positive nominal interest rate and a constant money-to-bond ratio, the supply of money must be rising at this same rate.) At the same time, this higher rate of debt-issue is used to finance a higher primary budget deficit (just think helicopter drops again).

Well, putting things this way makes it seem like there's no substantive difference between the two views. Personally, I think this is more-or-less correct, and I believe that Nick Rowe might agree with me. I hestitate a bit, however, because there may be some hard-core "Neo-Wicksellians" out there that try to understand the interest rate - inflation dynamic without any reference to fiscal policy and nominal aggregates. (Not sure if this paper falls in this class, but I plan to read it soon and comment on it: The Perils of Nominal Targets, by Roc Armenter).

If the view I expressed above is correct, then it suggests that just limiting attention to (say) the dynamics of the Fed's balance sheet is not very informative without reference to the perceived stance of fiscal policy and how it interacts with monetary policy. Macroeconomists have of course known this for a long time but have, for various reasons, downplayed the interplay for stretches of time (e.g., during the Great Moderation). Maybe it's time to be explicit again. Let's help Nick keep his beard.

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